•

Chapter 4

Specific Factors and Income Distribution

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Introduction

• From the Ricardian model, we learned that countries are always better off under free trade.– Specialization according to comparative advantage increases

world output and welfare

If it increases welfare, why is there so much opposition to trade liberalization?

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Introduction

• Opening a country to trade has strong effects on the distribution of income within a country.

• Following trade liberalization, some industries• contract resulting in unemployment• others expand resulting in higher factor payments

• Industries differ in the factors of production they demand, such that the welfare impact of trade will vary across factors (e.g., different types of workers or capital).

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Introduction

What is the impact of trade on thedistribution of income within a country?

• In the Ricardian model, there is only one factor of production (labor), so we cannot study the effect of trade on income distribution.

• We need to develop new models that include multiple factors of production, i.e., multi-factor models.

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Introduction

1. Specific-factors model (Chapter 4) – Some factors are specific to each sectors and cannot relocate

across sectors (zero mobility)– The specific-factors model is a short-run model

2. Heckscher-Ohlin model (Chapter 5)

– All factors can relocate across sectors at no costs (perfect mobility)

– The Heckscher-Ohlin model is a long-run model

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Introduction

• Recall that there are potential gains from trade whenever there is cross-country variation in autarky prices.

• In the Ricardian model, differences in autarky prices come from differences in technologies across countries.

• In the multi-factor models:– Technologies are the same in all countries– Trade patterns are explained by cross-country differences in

relative factor endowments

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Introduction

• We begin by looking at the distributions of population, capital and agricultural lands across countries.

• This will make clear that:– While population and capital stock are generally greater close

to agricultural lands– Population, capital and agricultural lands are not evenly

distributed across countries. In other words, there are differences in relative factor endowments across countries.

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Introduction

Source: http://www.worldometers.info

World Population Density (people/km2)

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Introduction

Credit: Image by Craig Mayhew and Robert Simmon, NASA GSFC.

EARTH'S CITY LIGHTS

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Introduction

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The Specific-Factors Model

• Assumptions

• Earnings of labor

• Earnings of specific factors

• Summary and conclusions

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Specific-Factors Model

• Assumptions of the model

1. Two sectors: Agriculture and Manufacture

2. Three factors of production: labor (L), capital (K) and land (T for terrain)

3. Perfect competition prevails in all markets

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Specific-Factors Model

1. Supply

• The economy produces Manufacturing and Agricultural goods

– Manufacturing uses labor and capital:

– Agriculture uses labor and land:

• Labor is perfectly mobile across sectors but capital and land are specific to their industry.– As usual, factors cannot relocate across countries.

)K,L(FQ MMMM =

)T,L(FQ AAAA =

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Specific-Factors Model

• Full employment in factor markets implies that supply is equal to demand:

TTKK

LLL

A

M

AM

=

=

=+

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Specific-Factors Model

§ In each industry, the marginal product of labor declines as the amount of labor used in the industry increases.

§ This happens because there is a fixed amount of the specific factor.§ There are decreasing returns to scale.

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Specific-Factors Model

Production Possibilities Frontier

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Specific-Factors Model

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Specific-Factors Model

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Specific-Factors Model

2. Demand

• Assume that consumer preferences can be represented by a well-behaved utility function: U(CM,CA).

• The representative consumer maximizes utility subject to the budget constraint : I = PMCM+ PACA

• The optimal relative demand for good M is such that

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Specific-Factors Model

3. Closed economy equilibrium

• Consumers maximize their utility:

• Firms maximize profits:

• All markets clear:

Combining those results:

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Specific-Factors Model

4. Foreign country

• Same as Home expect for endowments of labor, capital, and land

• Assume Home has comparative advantage in manufacturing

– The autarky relative price of manufactured goods is higher in Foreign than in Home: (PM/PA)* > PM/PA

– Moving from autarky to free increases the relative price of manufacturing in Home

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B

Specific-Factors Model

Slope = –(PM/PA)W

UA

QM

A

QA

PPF

§ Autarky (point A): production and consumption are equal.

§ Under trade, production (point B) and consumption (point C) no longer need to be equal.

§ Home exports good M and imports good A

§ The rise in utility from UA to UCis a measure of the gains from trade for the economy.

5. Autarky vs. Trade Equilibrium

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Specific-Factors Model

• As in the Ricardian model, the welfare of the average consumer is higher.

• However, in the specific factors model that does not imply that everyone is better off. When input ownership is not distributed evenly across consumers, there will be both losers and winners

How are earnings of labor, capital, and land affected in importing and exporting industries after trade?

• Specific factors model notes

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Summary

• Following an increase in the relative price of manufactures:

– Labor can buy more food but less manufactured goods. So the welfare effect on workers (the mobile factor) is ambiguous.

– Capital (specific to manufactures, the export good) owners can afford more of both goods, they are better off.

– Land (specific to agriculture, the import good) owners can afford less of both goods, they are worst off.

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Trade Policy

• In the specific-factors model:

– Trade benefits a country by expanding the set of choices available. However, not everyone gains from trade.

– Average welfare increases following the opening to free trade.• Therefore, the gains outweigh the losses• Those who gain can compensate those who lose and still

be better off themselves.• Caveat: the “market” itself will not do this and

redistribution usually hard to implement.

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Trade Policy

• Trade policy must weigh one group’s gain against another’s loss

– Some groups may need special treatment because they are already relatively poor

– Typically, those who gain from trade are a much more concentrated, informed, and organized group than those who lose

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Trade Policy

• Trade shifts jobs from import-competing to export-competing sectors.

– Process not instantaneous – some workers will be unemployed as they look for new jobs

– Governments usually provide a “safety net” of income support to cushion the losses to groups hurt by trade (or other changes)

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Trade PolicyHow much unemployment can be traced back to changes in trade flows?No clear pattern

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Trade Policy

• Economists tend to favor free trade

– It is easier to use “macro” policies than to regulated each industries separately.

– Policies introduce distortions which makes it difficult to evaluate their (full general equilibrium) impact.